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What is Arbitrage
Economics observes that there is an advantage being taken in case there is a difference in markets. Arbitrage is taking the maximum possible advantage of the price variations that arise. It is mostly done in the case of single assets or identical assets.
In the case of Arbitrage, it is taken to be a kind of transaction wherein there is no chance for any kind of negative flow in the cash, in the case of a problem.
There would also be a positive flow of cash in some cases too. This signifies that there is a state of profit when it is risk-free.
In the case of arbitrage, though risk-free there are slight variations that are seen in the profit margins.
These are due to minor fluctuations in the prices and also due to some major causes like the devaluation in the case of the currencies.
There are people who are specifically engaged for the purpose of arbitrage. They are known as the arbitrageurs.
They are the firms that are involved in brokerage, which could be a banking enterprise and industry like shipping etc.
It is applicable for the cases of bonds, stocks, and similar things that are marketable and are traded.
Wha is Arbitrage Equilibrium
Arbitrage Equilibrium arises when there is no change happening in the market. The market prices are not effectively allowing a profit. This is also called as the arbitrage-free market.
Usually, this is something that comes before the condition of market equilibrium. When there is no arbitrage, there are possibilities to calculate the risk-neutral prices in case of the products that are derivatives of some sort.
When can arbitrage be possible?
It is very important to be aware of the situations that can actually lead to arbitrage. They can be one of the following:
A) The same price cannot be expected for the same product in a different market setting.
B) The same price will not be given to the products of an identical kind.
C) The cost of a product can be expected to give you the same amount as today or as you would expect it to be in the future. This implies that there are no guarantees.
Mathematically it can be said as:
Example:
Where V0 = 0 and Vt is the portfolio value at a given time t.
Let us take an example to understand this more clearly.
The stock exchanges of New York and the Security Futures Exchange of Chicago have exchange rates that are not the same for a particular product traded on their platforms.
Hence, then you can choose to buy it from them at a lesser price and sell it to the other at a higher rate. You have a choice.
Since usually there is not much of a difference, it has to be carefully done. This would be needed in order to avoid the risk being taken in such a case.
This would be of help to those arbitrageurs who are in possession of fast computers and greater expertise as they have an edge over the rest.